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Category Archives: Monetary Theory

Exceptions hinging on excess demands for non-currently produced goods other than money are not inconceivable but would be economically unrealistic. In the General Theory, Keynes remarks that a deficiency of demand for current output might be matched by an excess demand for assets having three “essential properties:” (a) their supply from private producers responds slightly if at all to an increase in demand for them; (b) a tendency to rise in value will only to a slight extent enlist substitutes to help meet a strengthened demand for them; (c) their liquidity advantages are large relative to the costs of holding them. Another point that Keynes notes by implication belongs explicitly on the list: (d) their values are “sticky” and do not adjust readily to remove a disequilibrium.

Money is the most obvious asset having these properties. Keynes asks, however, whether a deficiency of demand for current output might be matched by an excess demand for other things instead, perhaps land or mortgages, Other writers have asked, similarly, about other securities, works of art and jewelry.

My answer is no. Such things might be in excess demand along with but not instead of money. Money itself would also be in excess demand. One reason is that all other exchangeable things trade against money in markets of their own and at their own prices expressed in money. (This is rue even of claims against financial intermediaries if their interest rates count as corresponding, inversely, to prices.) An excess demand for a good or a security tends to remove itself through a change in price or yield. If, however, interest rates should resist declining below the floor level explained by Keynes and Hicks, people would no longer prefer additional interest-bearing assets to additional money, and any further shift of demand from currently produced goods and services to financial assets would be an increase in the excess demand for actual money in particular. (If stickiness or arbitrary controls should keep prices and yields of financial assets from adjusting and clearing the market, the situation would be essentially the same as in the case of price rigidity of other assets…). The monetary interpretation of deficient demand for current output thus does not depends on any precise dividing line between money and assets; if money broadly defined is in excess demand, money narrowly defined must be in excess demand also. Unlike other things, money has no single definite price of its own that can adjust to clear a market of its own; instead, its market value is a reciprocal average of the prices of all other things. This “price” tends to b sticky for reasons almost inherent in the very concept of money.

Five months ago, I laid out the beginnings of an explanation for price rigidity, based on the concept of imperfect competition. One of these days, I’ll think through the idea a bit more, build a model, and see if there’s actually anything there. For the time being, some superficial evidence will have to do.

My theory posits a situation where an uneven distribution of the demand shortage can change the distribution of market power, under the assumption of product differentiation,

Suppose an industry with n firms is impacted by a fall in demand, caused by a rise in the demand for money. To make the model clearer, let’s take it to the extreme and assume that only one firm suffers the demand shortfall, such that n–1 firms can continue to sell the same quantity of output at the same price. Further, suppose that the distribution of inputs to firms is symmetric, implying that the higher the value of n is, the less the one firm can influence the price of inputs (i.e. if all firms reduce their demand for inputs, the price of inputs will fall). The result is that the one firm has to reduce its output, and the inputs that otherwise would have been purchased are now idle.

Or, assume an uneven distribution of market power (still an imperfectly monopolistic market). Further, suppose there is a recession and a subsequent demand shortage. My theory is that firms with greater market power — who are in a better position to weather the decline in receipts — can keep input prices relatively high, where firms less able to survive the recession are forced to pay input prices above what would be the case in a perfectly competitive market.

Do European football markets offer some evidence for this theory? Consider Spain’s La Liga, where you have two clubs who are dominating European football (Real Madrid and Barcelona) and 18 which are struggling domestically. Despite the generally poor financial state of Spanish football, Real Madrid and Barcelona can essentially buy whatever players they want at higher prices than any competitor (e.g. €57 million for Neymar; €91 million for Bale; €94 million for Cristiano Ronaldo; €35 for Illarramendi; €30 million for Isco; …the list goes on and on). Together with other European clubs with relatively high market power, such as Bayern Munich, Manchester United, Paris Saint Germain, Chelsea, Manchester City, et cetera, they raise the price of quality players. They raise the price level, so to speak.

Let’s generalize and say that a club’s value marginal product is a function of the quality of its players. The other 18 Spanish football teams, who are struggling financially because they are affected more by the demand shortage than R.M. and Barça, now face a higher price level than what would be the case if market power were more evenly distributed. This makes buying quality players very difficult. With reduced incomes, they can’t afford these players at existing prices. They opt for lower quality substitutes (although, youth academies can also occasionally produce youths of high quality), and the average quality of input falls. This is the same thing as saying that their output, and therefore real income, declines.

Clubs with typically tight budget constraints typically turn to youths (~18–22 years old). A club with a mean quality that allows it to place somewhere within the top 10 by the end of the season might have 1–3 truly high quality youths (with the average probably closer to 1). If they have a high debt burden, with falling real incomes, they can earn a good return by selling their youths to clubs of high market power. Real Sociedad sold Illarramendi for €35 million to Real Madrid; Málaga sold Isco to Real Madrid for €30 million; Sevilla sold Geoffrey Kondogbia for €20 million; Atlético Madrid has had to raise the buy-out clauses for their youth players, in case they can’t match their wealthy competitors’ wage offers. The result is that clubs find it difficult to retain the talent they produce at home. In other words, clubs with higher market power can offer their less well off, debt-constrained competitors a price that compensates them for foregoing the opportunity to use (and develop) their youths and sell them at a future date.

Generalizing, the process of buying youth-academy products from debt-constrained clubs is analogous to high market power firms buying their low market power rivals’ best inputs. Say that an input produces a continuous stream of output over some period of time. In this case, firms with high market power can pay a current price that makes it worthwhile for debt-constrained clubs to forgo the alternative of earning the continuous flow of revenue. They also have to compensate the seller for forgoing the expected future value of the player. This type of horizontal exchange of inputs is probably not relevant for most goods, but it does seem relevant for the one good that we typically think of suffering from price rigidity: labor.

But, an unequal distribution of market power can apply to many industries, and this may mean that these markets are prone to price levels that force smaller firms to cut output, because they can no longer afford to buy as many inputs (or they have to substitute with lower quality inputs).

Other collections of readings on money, like standard textbooks on money and banking, convey a false impression of the authority of received doctrine. In truth, contemporary monetary theory is among the least-settled branches of economic analysis and no serious student of modern economics can afford to be ignorant of this fact — or of the reasons for it.

Yesterday on Facebook, someone asked an interesting question on cryptocurrencies and inflation. One of the attributes that, to some degree or another, makes gold currency stable is that gold is in strict supply. It’s costly to mine, and there is a limit to how much there is available to mine. Monies that don’t have a similar constraint have to establish alternative institutions, such as the inter-bank clearing mechanism in George Selgin’s theory of free banking. Cryptocurrencies don’t have the same physical scarcity as gold — a new firm (which I will use as a catch-all term for individuals, groups, hackers, coders, whatever…) can introduce a new algorithm, and with it a new cryptocurrency —, and sophisticated institutional constraints have not yet arisen. Does this mean that cryptocurrencies are destined to an inflationary demise?

Different currencies are imperfect substitutes to each others. There is some degree of brand discrimination, in that people oftentimes prefer one over another. Different cryptocurrencies are different goods, and the marginal value of one is not the same as the marginal value of another. The broad implication is that the overall supply of all types of cryptocurrency does not determine the marginal value of the individual brands. These are determined by their own supply and demand schedules, even if these curves are inter-related. For example, suppose that the “GoogleCoin” firm issues an excess supply of its currency, dramatically reducing the value of the marginal “GoogleCoin.” If we hold all else equal, this doesn’t mean bitcoin’s marginal value will fall with “GoogleCoin’s.” In fact, individuals may want to reduce their “GoogleCoin” balances and increase their bitcoin holdings, implying an increase in demand for the latter (and a corresponding increase in its marginal value).

The same idea holds true with modern currencies. Hyperinflation in Zimbabwe does not cause, all else equal, similar effects on the U.S. dollar or the euro. The marginal value of the two latter currencies are determined by their own supply and demand schedules. In fact, the hyperinflation of the Zimbabwe dollar shifted the demand curve for currencies like the South African rand to the right, because individuals were looking for a more stable currency. We can conceive of a situation where several paper monies are quickly loosing value, because of, say, hyperinflation, while another paper currency elsewhere — benefiting from effective institutional constraints — remains relatively strong and stable.

What matters for a currency to be stable is that there are limits to how many units can be issued. Bitcoin’s approach to this issue is to include an asymptote to its money supply function. I’m sure other cryptocurrencies are similar. If cryptocurrency markets get more complicated, more sophisticated institutions might be necessary to help ensure monetary stability, but for the time being these kind of built-in limits to supply essentially mimic the relevant natural attribute of gold: physical scarcity.

Throughout this discussion, I’ve assumed that there are established cryptocurrency monies. Currently, this assumption may not hold. I don’t generally follow the cryptodebate, but I believe it’s contested that bitcoin is really money. The guidelines to what is money and what isn’t are somewhat ambiguous, because the overarching quality of money is its liquidity. But, there is a continuous range of liquidity (or, borrowing from J.P. Koning, moneyness) that a set of assets can lie on. Money is generally considered the most liquid asset, but different currencies can certainly have different degrees of liquidity (the Rothbard dollar may be accepted over a larger geographic area than the Mises peso).

The supply of money is always determined by the demand for money. When something is already money, supply can create its own demand. Without strong institutional constraints — something that creates a quick process of reflux —, an excess supply of money raises the price level and may induce individuals to increase their desired cash balances. But, new cryptocurrencies are not automatically money. They have to earn that liquidity by being widely accepted as a unit of exchange. Their moneyness depends on the demand for its liquidity. The implication is that any new brands that are money candidates cannot be supplied in excess, because changes in their supply are determined by changes in the demand for them as money. If bitcoin were already a widely traded general medium of exchange, and if there were no constraints on its supply, an excess supply of them may create its own demand, but there are built-in constraints to its supply. Further, since bitcoin is in a relatively competitive environment, dramatic changes to its marginal value may drive individuals to get rid of their bitcoin and increase their holdings of alternative currencies.

If existing cryptocurrencies are unstable, it’s not necessarily because of a lack of constraint on their supply. The majority of, if not all, cryptocurrencies are not money, they’re just non-money assets (valued for whatever reason). They are volatile assets, because the source of their demand is volatile. And, they are just as prone to bubble behavior as any other financial asset: false profits leads to malinvestment, and all of that.

If cryptocurrencies do catch on and they begin to be valued for their liquidity (that is, as money), I don’t see any obvious reason for instability. This may change as the financial system adapts to these cryptocurrencies — depending on the institutions that develop along with it —, but the built-in rules that limit the supply of different brands of cryptocurrency mimic the physical scarcity of gold.

Before 1974, U.S. dollars were backed by gold. This meant that the federal government could not print more money than it could redeem for gold. While this constrained the federal government, it also provided citizens with a relatively stable purchasing power for goods and services. Today’s paper currency has no intrinsic value.

I think “intrinsic value” here has a different meaning from how an economist define “intrinsic value.” Gold is valued for other ends — jewelry, industrial uses, electronics, et cetera —, but this fact confuses people into thinking that gold has “intrinsic value.” But, the source of value for gold as money is the same as the value ascribed to paper monies. Money is valued as a general medium of exchange, meaning for its liquidity (money is the most liquid asset). Corollaries to this main function, money is also a medium of account and, potentially, a store of value.

I’m not making this point just to stress the subjectivity of value (the value of something is imputed from the ends that good is a means toward). Well, in a way I am, because my main point is that “paper currency has no intrinsic value” is a bad argument against paper money. In terms of sources of value, paper and gold are no different. So, if paper currency has no intrinsic value, neither does gold.

This doesn’t mean paper is preferable to gold. (I wouldn’t say that gold is preferable to paper, either. A competitive, free banking system would probably use both; although, maybe there are better assets than gold.) The reason it’s often assumed that a gold standard would lead to a relatively stable price level is because gold is rare, which makes it relatively scarce compared to potential alternative monies (e.g. shells, cows, bushels of wheat, Rai stones, et cetera). But, gold standards can be politically manipulated, and they have been — the inter-war and the post-war gold standards were not the same monetary system that existed during the 19th century. The best “standard” we can have isn’t a particular material from which to produce our money, but a competitive, free banking system.

Behind the talk is the notion that monetary spending makes the economic world go round. It does not. Increasing the money supply does not magically increase the quantity of land, labor, or capital goods available for production. Creating money out of thin air does not produce more consumer goods, and there is the rub. We cannot eat money. We cannot wear money. We cannot live in money. Even the Beatles knew that money can’t buy you love.

The line “you can’t print wealth into existence” is commonly used, and apart from being a criticism of monetary policy it stems from the, correct, belief that only capital goods are productive and only consumer goods can actually satisfy our ends. Money is an intermediary, a lubricant, that makes indirect exchange easier by providing a highly liquid medium of exchange; money is accepted by almost everybody, carburetors, your labor hours, and apples aren’t.

But, it isn’t a good criticism of monetary policy, whether public or private. While others have addressed the mistake before, they do so by embracing the allegory (e.g. Timothy Lee and Paul Krugman). While the substance of their responses are absolutely right, accepting that “you can print wealth into existence under certain conditions” is misleading. I peddled the same critique even three years ago, and I wouldn’t have seen the merit of the reply. Someone who is focused on the real sources of productivity isn’t going to be swayed to the idea that, in the right environment, printing money creates wealth. It takes away from what the real point is: a shortage of money can price productive goods out of the market.

In an equilibrium economy with quantity of money M, prices will reflect opportunity costs and there will be neither a shortage or excess of money. Suppose there is some “shock” (i.e. malinvestment, animal spirits,…), and you — along with most other members of your economy — decide to increase the amount of money you hold (leave unspent). Maybe you do this because the shock makes your future options and standard of living unclear, or uncertain. This event is called an increase in the demand for money, and it implies that the value of money increases. Prices reflect relative valuations, so if the value of money rises, the relative value of other things must fall: prices must fall. If prices don’t fall, the smaller amount of money that people are willing to exchange is going to buy a smaller amount of goods.

Few serious economists actually posit a direct relationship between “printing money” and creating wealth. But, if prices don’t fall after an increase in the demand for money, the volume of trade will collapse: there will be productive goods that were once traded, but no longer are. If less factors of production are being purchased, less output is being produced: our standard of living falls. The point behind increasing the quantity supplied of money isn’t to create wealth, but to sustain the volume of exchange that allows for an economy producing at its maximum output.

This doesn’t mean all monetary policy is good. There are different ideas for equilibrating the demand for and supply of money. Policies which target inflation expectations are meant to induce people to reduce their cash holdings; inflation is a reduction in the value of the marginal dollar, and if you expect your money holdings to fall in value you have a greater incentive to exchange that money for goods (the relative value of those goods increase). NGDP targeting seems more ad hoc: anything goes, as long as that NGDP target is hit. But, individual policies, or “transmission mechanisms,” come with costs and benefits of their own. No policy is created equal, and it doesn’t make sense to me to not scrutinize between them.

But, if there is a collapse in the volume of trade caused by a shortage of money, it’s a sensible option to increase the quantity supplied of money, especially if prices — whether all or only some (i.e. labor) — are sticky. Money is not directly productive, but it’s a lubricant by which we can move productive resources around and utilize them to increase (or maintain) our standard of living.

James K. Galbraith has written a strange piece for the New York Times, where he muses on the debt ceiling. He argues that the necessity for government to borrow money is an “anachronism,” product of the gold standard. In answering why the government doesn’t just create new money, he claims that “to do so would expose the “public debt” as a fiction, and the debt ceiling as a sham” — as if the constraint on debt monetization is nonsensical or ideological. Galbraith, however, gets his history wrong, and as a result gets the answer to his question wrong. Governments have tried to get around borrowing constraints throughout history, and the reason we toughen these constraints is exactly because unconstrained governments have misused the power to debase their currency.

Prior to the 20th century, it was often that governments attempted to avoid their financial constraints. The Roman Empire, for example, frequently underwent currency debasement to pay for growing bureaucratic and military expenses (Bartlett [1994]). The Spanish Empire also relied on seigniorage for financing (Motomura [1994]), on top of the new silver and gold it imported from its colonies — this lead to the “European price revolution,” as the value of money fell sharply. Governments don’t need paper money to spend without borrowing. In the era of metallic currencies, all government had to do was lower the content of the precious metal in the coin — replacing it with a less valuable substitute (e.g. copper) —, and encourage acceptance at par.

Contra Galbraith, there were (and remain — after all, economic laws are immutable) economic constraints on seigniorage. By lowering the value of money, and redistributing resources away from non-government market participants, significant and sustained currency debasement leads to the deterioration of exchange. It is no accident that, ultimately, the most successful imperial government that emerged from the pre-modern milieu was England, which made use of a growing finance industry to borrow larger sums of money than rival governments could. English society had learned from a multitude of previous experiences that currency debasement is not a permanent solution to financial constraints, and that over the long run inflationary expenditure is more harmful than anything else.

It could be argued that modern, democratic governments have constraints of other types that would limit the extent of seigniorage. Perhaps, but it wasn’t too long ago that modern governments resorted to the printing press to get around financial constraints. This led to the great inflations and hyperinflations that followed the First World War. Similar to pre-modern experiences, this public finance technique led to the deterioration of European markets, and ultimately the only viable solution was to place a ceiling on public budgets. Now, I do think that we learned “too much” from this experience, making monetary policy more rigid than it really needs to be: case-in-point, the Great Depression. But, there is a big difference between constrained, but flexible-enough monetary policy, and unconstrained inflationary fiscal expenditure.

Increasing the quantity supplied of money is not always a bad thing. When there is a demand shortage increasing the quantity supplied of money is oftentimes a superior alternative to waiting for the price level to fall, because many individual prices do not always fall to their market-clearing level. Maybe what we need today is more money (although, given that the price level has been rising I’m skeptical of the idea that a demand shortage is currently the most important deterrent to economic recovery). But, lifting the constraints on public finance is not a solution. Maybe the current administration, and even many administrations to follow, can be trusted, but political institutions can deteriorate, especially when government is under financial pressure. The reason we don’t voluntarily dismantle them voluntarily is because the risk of gratuitous inflationary public finance is very real, and it has been something governments have resorted to since the beginning of governed civilization.